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What Property Qualifies for a 1031 Exchange? (Part Three)

This is Part Three of our series on what property qualifies for a 1031 exchange.  You can also see Part One and Part Two.

In deciding whether a particular property has been held for productive use in a trade or business or for investment, the IRS looks at how you have characterized that property on your tax returns. If you have historically taken depreciation on or reported rental income on a property, there should not be any problem with that property qualifying for a Section 1031 exchange.

In addition, it is important to note that the IRS has ruled that the Section 1031 requirement that property be “held for productive use in a trade or business or for investment” excludes primary residences, vacation homes (when they are not held for investment), and second homes. When a personal residence is exchanged for other property, the Section 121 exclusion rule applies (providing that up to $250,000 of capital gain, or up to $500,000 for a married couple, is not taxable), not Section 1031.

The burden of establishing that a property is held for productive use in a trade or business or for investment (and not for a non-qualifying use such as inventory for resale) is on the exchanger, not the government.

The “for investment” requirement is somewhat trickier than the requirement that the property be “held for productive use in a trade or business,” since all property could conceivably be considered an investment.

Each property must be evaluated on a case-by-case basis. What the IRS looks at is the intent of the property owner and whether, on balance, the property is held for investment purposes or personal enjoyment.

If you want to do a Section 1031 exchange of property that you now use as your primary residence or as a second or vacation home, you must first turn it into qualifying property that is productively used in a trade or business or for investment. In other words, even property you have used as a primary residence, a second home, or primarily for personal enjoyment as a vacation home, may still qualify for an exchange under Section 1031 – if you re-characterize that property by using it for business purposes for a sufficient period of time.

The date the IRS uses to determine whether property has been held for a qualifying business use is the date of the transaction; any previous use is theoretically irrelevant. There is also no clear rule regarding how long a “holding period” is required in order to re characterize property and qualify for a Section 1031 exchange. Tax advisors recommend a period of one to two years (opinion is split on which time period is sufficient, but in no case less than 12 months) in the new use, and that you are able to report rental income and deduct depreciation and other business expenses regarding the property on your tax returns for that period of time.

It should also be noted that one can also exchange many types of non-real estate property that is held for investment or used in a business. For example, an airline can sell its airplanes as part of a like-kind exchange and avoid recapture of depreciation.

But the “like-kind” requirement is interpreted much more narrowly by the IRS for non-real property than for real property. While any real property held for trade or business use or for investment and located in the United States can be exchanged for any other real property held for trade or business use or for investment use and located in the United States, non-real estate properties exchanged under Section 1031 must be essentially the same type of asset.

Airplanes can be exchanged for airplanes, trucks for trucks, pizza ovens for pizza ovens, oil digging equipment for oil digging equipment; but airplanes cannot be exchanged for trucks, and oil digging equipment cannot be exchanged for pizza ovens. In addition, franchise rights and certain types of licenses can also be exchanged under Section 1031.

The replacement property, like the relinquished property, must meet certain requirements to be eligible for a Section 1031 exchange.

First, the replacement property, like the relinquished property, must be property, not securities or services, and it must be intended for “productive use in a trade or business or for investment.” 

Section 1031 applies only to “the exchange of property…for property.” For this reason, you cannot exchange property for securities or services. As with the relinquished property, this is a matter of the how the exchanger intends to use the property. The use of either property by the other party in the exchange is irrelevant.

Second, the replacement property must be of a “like-kind” to the relinquished property. What does “like-kind” property mean? In a typically obtuse ruling, the IRS has stated that:

“As used in IRC 1031(a), the words like-kind has reference to the nature or character of the property and not to its grade or quality. One kind or class of property may not, under that section, be exchanged for property of a different kind or class. The fact that any real estate involved is improved or unimproved is not material, for that fact relates only to the grade or quality of the property and not to its kind or class. Unproductive real estate held by one other than a dealer for future use or future realization of the increment in value is held for investment and not primarily for sale.”

Got it? Okay, now let’s unpack the “like-kind” requirement in language that makes sense.

As used in Section 1031, “like-kind” property does not mean property that is exactly alike – or even alike at all in any normal sense. Instead, the IRS interprets the “like-kind” requirement very broadly – so broadly that if two or more properties are located in the United States and are held for productive use in a trade or business or for investment, they are considered “like-kind” property under Section 1031.

In other words, all real property located in the United States is considered “like-kind” to all other real property located in the United States.

Conversely, foreign property such as property located in Canada or Mexico) or in overseas U.S. possessions, such as Guam or Puerto Rico, is not considered “like-kind” to any property located in the United States.

But urban real estate in Los Angeles can be exchanged for a ranch in Utah, a ranch in Utah can be exchanged for a factory in Delaware, a factory in Delaware can be exchanged for a gas station in Las Vegas, and a gas station in Las Vegas can be exchanged for a conservation easement in Seattle. The quality or type of the real property does not matter so long as each real property is located in the United States. Under Section 1031, an apartment building in Chicago can be exchanged for an office building in Los Angeles, an office building in New York can be exchanged for a car wash in Nashville, a car wash in Seattle can be exchanged for a tenancy-in-common ownership in a resort in San Diego, and a tenancy-in-common ownership in a mall in Arizona can be exchanged fortimberland in Oregon, a farm in Wisconsin, a factory in Pennsylvania, or a gas station in Louisiana.

The fact that one property is improved and the other property is unimproved, or that one property is in a run-down part of a city while the other property is located in an upscale neighborhood is irrelevant.  Moreover, even partially completed property can, if properly identified, qualify as “like-kind” property with completed property. The “like-kind” requirement refers to the nature or character of property, not to its grade or quality. As long as a property is located in the United States and is “held for productive use in a trade or business or for investment,” it is “like-kind” to every other property located in the United States that is “held for productive use in a trade or business or for investment.”

See also “What Property Qualifies for a 1031 Exchange?” Part One and Part Two.

To contact Melissa J. Fox for 1031 exchange or other real estate or legal services, send an email to strategicfox@gmail.com

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What Property Qualifies for a 1031 Exchange? (Part Two)

To qualify for the tax benefits of an exchange under Section 1031, the property you want to exchange (or relinquish) needs to be “held for productive use in a trade or business or for investment.”

For income tax purposes, real estate is divided into four classifications: (1) property held for business use, (2) property held for investment, (3) property held for personal use, and (4) property held primarily for sale (“dealer property”).

Only property that is held for business and property held for investment qualify for an exchange under Section 1031.

Property held for personal use and property held primarily for sale do not qualify.

Section 1031 does not define either “held for productive use in a trade or business” or “held for investment,” but over time, court cases and IRS rulings have clarified what these terms mean in most instances.

Examples of property that is “held for productive use in a trade or business” and clearly qualify for a Section 1031 exchange include all buildings owned and used by a business, such as factories and office buildings, as well as rental apartment buildings.

Examples of property that do not qualify for a Section 1031 exchange are stocks, bonds, or notes, certificates of trust or beneficial interest, choses in action (a right to recover money or other personal property in a judicial proceeding), or other securities or evidences of indebtedness (with the exception of a 30-year or longer lease).

It does not matter if any of the excluded property items are related to real estate; they are always excluded from Section 1031 exchange.

For example, a note can never qualify for a Section 1031 exchange, even if the note is secured by real property.

Also disqualified from exchange under Section 1031 is inventory, stock in trade, or any other property that is held primarily for sale rather than business use or investment (known as “dealer’s property”).

Property is considered inventory, and therefore not qualified for a Section 1031 exchange, when it is held for sale to customers in the ordinary course of business. For example, if you own a business that sells airplanes, you cannot use one of those airplanes as qualified property for a Section 1031 exchange.

The dealer property exclusion rule also means that real property held for sale by dealers in real estate does not qualify for Section 1031 exchanges.

In determining who is a dealer in real estate, the IRS looks at the facts and circumstances of each case and makes its determination on a property-by-property basis.

While there are no hard and fast rules in this area, in general, the questions the IRS asks are: what is the nature of the taxpayer’s business; for what reason and purpose was the property acquired and/or transferred; for what length of time was the property held; what are the number and frequency of sales; what kinds of construction improvements and subdivision activity was undertaken on the property; did the property have income-producing potential; and what is the percentage of real estate sales as compared to the taxpayer’s other income.

It is important to note that you do not have to be in the business of buying and selling real estate to be treated as a dealer by the IRS. If you are required by the buyer of the relinquished property to undertake subdivision activities or other work in preparation for the buyer’s development of the property, you may be considered to be in a joint real estate venture with the buyer, and the IRS could disqualify the exchange as involving dealer property.

Similarly, an exchange under Section 1031 is not available for real estate “flippers.” “Flipping” property refers to the practice of buying real estate and then quickly reselling it (with or without making improvements) at a higher price.

Property that is “flipped” is not eligible for the tax benefits of Section 1031 for the same reason as the exclusion of dealer’s property. As noted, dealers in real estate may not use Section 1031 because they hold real estate for resale (that is, as stock-in-trade or inventory), and a quick resale (or attempted exchange) of recently acquired real estate signals to the IRS that the property is being used for inventory, not for productive use in a trade or business or for investment.

The bottom line is that you must remain aware of the requirement that both the relinquished and the replacement properties be held for use in a trade or business or for investment rather than resale. If the IRS concludes that either the relinquished property or the replacement property is held by the taxpayer for the purpose of resale rather than use in a trade or business or for investment, then the property will be disqualified from the Section 1031 exchange process
and capital gains taxes must be paid.

In deciding whether a particular property has been held for productive use in a trade or business or for investment, the IRS looks at how you have characterized that property on your tax returns. If you have historically taken depreciation on or reported rental income on a property, there should not be any problem with that property qualifying for a Section 1031 exchange.

Property that does not now qualify for a 1031 exchange can be recharacterized for tax purposes by using it for a trade or business or for investment.

Although there is no absolute rule regarding exactly how long the property must be held for use in a trade or business or for investment before it is recharacterized and can be exchanged – and the IRS insists that it will examine each exchange on a case-by-case basis – most professionals recommend planning for a holding period of two years.

In any event, the best way to ensure that this requirement is met is to consult with both your attorney and your tax advisor regarding the potential for any holding period problems in your agreement with the buyer for your relinquished property, as well as your future plans for your replacement property.

For more information on this topic, and for everything you need to know about 1031 exchanges, see our book 1031 Exchanges Made Simple, available at Amazon.com.

To contact Melissa J. Fox about serving as a qualified intermediary or for other 1031 exchange services, send an email to strategicfox@gmail.com

For Part One of this article, click here.

For Part Three of this article, click here.

What Property Qualifies for a 1031 Exchange? (Part One)

The basic elements of a deferred exchange under Section 1031 are (1) a qualified relinquished property; (2) a qualified “like-kind” replacement property; (3) a qualified replacement property owner; (4) replacement property of equal or higher market value than the relinquished property; (5) no real or constructive receipt of the proceeds; and (6) strict adherence to the time limits for identifying and closing on replacement property.

Every one of these elements is necessary for a valid Section 1031 exchange. If any one of these elements fails, the IRS will not recognize the transaction as a Section 1031 exchange but as a sale and you will be required to pay capital gains taxes.

What is a Qualified Relinquished Property?

You must begin with ownership of a tangible property that is qualified for an exchange under Section 1031.

There are really two requirements here.

First, what is being exchanged must be tangible property. Second, both the relinquished property and the replacement property must be “held for productive use in a trade or business, or for investment.”

You can only exchange tangible property for tangible property. Section 1031 applies only to “the exchange of property. . . for property.”

In other words, in order to qualify for the tax benefits of an exchange under Section 1031, what is being exchanged must be ownership of tangible property (such as land, buildings, mineral deposits, or uncut timber), not a security (such as stocks and bonds),services, or a lease or rental interest.

The property requirement also raises questions regarding the forms of property ownership. There are several ways to own property. The most obvious way to own property is by sole and unrestricted ownership.

Sole ownership means that you are the only person who owns all of the interest in a piece of property.

In sole ownership, with the exception of some legal restraints such as maintaining a public nuisance, zoning restrictions, infringing on the rights of others, and the possible interests of a surviving spouse, you may do whatever you wish with your property, both during your lifetime and, through a will, even after your death. Sole owners can sell, exchange, mortgage, give away, or will their property however they choose.

In addition to sole ownership, there are also several ways to own real property in co-ownership with others. Co-ownership of property exists when two or more persons (or business entities) hold title to the same property.

The most important forms of co-ownership of real property are joint tenancy and tenancy-in-common. Both joint tenancy and tenancy-in-common involve what is called an undivided interest in the property. An undivided interest in real property means that each co-owner owns a proportional share (sometimes called a “fractional” interest) of the total value of the property.

Co-ownership of an undivided interest in real property means that one co-owner cannot claim the more valuable part of a property while asserting that the other co-owners possess only the less valuable parts. Instead, each co-owner owns a proportional share of the entire property.

In a joint tenancy, two or more persons (or business entities) own undivided interests in the same property with what is called a “right of survivorship.” This means that if one joint tenant dies, the property belongs solely to the surviving joint tenants, not to any possible heirs or beneficiaries of the deceased co-tenant, since property owned by joint tenancy cannot be transferred by a will.

Because of the right of survivorship, joint tenancy is most commonly used in family situations; that is, between husband and wife, parents and children, or grandparent and grandchild. Common examples of joint tenancy are a bank account in your name and your spouse’s name, a certificate of deposit with your name and the name of one of your children, and a government bond with your name and the name of a relative such as a husband, wife, child, or grandchild.

In theory, the primary advantage of ownership of property by joint tenancy is that probate is avoided or minimized, the property passes immediately and automatically to the surviving joint tenants. In addition, because property that is owned by joint tenancy passes immediately and automatically to the surviving joint tenants, it is protected against any claims by the deceased joint tenant’s creditors.

Among the primary disadvantages of owning property by joint tenancy are that it prevents the property from passing through inheritance to your heirs and beneficiaries, it lacks the flexibility to adapt to new circumstances such as divorce or remarriage, and serious problems can arise if one joint tenant sells or wants to sell a piece of property and the other tenants did not want it sold.

In addition, although joint tenancy is often used as an estate planning tool (in order to transfer property while avoiding probate and shielding property from creditors), it usually results in undesirable tax consequences when the property is eventually sold because the surviving joint tenants have received only a partially stepped-up basis.

Moreover, if there is a joint tenant who is not your spouse, the entire value of the property would be included in the taxable estate of the first tenant to die unless the other tenants could prove that they contributed to its purchase.

For all these reasons, ownership by joint tenancy is not favored for investment property or any property that is not co-owned only by close family members.

In a tenancy-in-common, two or more persons (or business entities) own undivided interests in the same property without any right of survivorship. This means that each of the tenants-in-common has the right to sell, exchange, mortgage, give away, or, unlike joint tenants, transfer by will his or her proportional share of the property.

In contrast to joint tenancy, the tax consequences of inheriting tenancy-in-common property are straightforward and predictable; the inheriting person gets a full step-up in basis on that portion of the property.

A potential disadvantage of ownership by tenancy-in-common is that the property passes to the estate of any deceased tenant-in-common, and so is subject to probate, estate taxes, and the claims of the deceased tenant-in-common’s creditors.

For this reason, property that is to be co-owned by close family relations whom you are absolutely certain you want to inherit your property at your death are sometimes better held in a joint tenancy. On the other hand, property owners can exchange a single large property through a Section 1031 for several smaller properties, and thus, divide their estate so that it can be bequeathed relatively easily to their heirs.

The advantages of a tenancy-in-common are numerous.

Investment in a property held as a tenancy-in-common can typically provide a larger and more stable investment than the same monetary investment in property held as either sole ownership or joint tenancy.

Tenancies-in-common also provide greater ease 0f investment and lower acquisition risk than joint tenancies and sole ownership.

Perhaps most importantly for real estate investors who are contemplating a Section 1031 exchange, suitable tenancies-in-common are often easier to identify and acquire within the exchange statute’s strict time limitations than other properties.

All environmental reports, title work, and other background research has already been done by a sponsor, preventing surprises and resultant delays – or worse – such as title problems, inspection delays, toxic waste issues, or boundary disputes, any of which can hold up escrow and potentially be fatal to a Section 1031 exchange.

Significantly, owning property through a tenancy-in-common can maximize the benefits of real property ownership while providing relief from many of its most troublesome headaches and uncertainties.

Because tenancies-in-common are typically managed by professional management companies, you will no longer have to deal with the problems of collecting rent, avoiding vacancies, negotiating leases, demands for repairs and other tenant complaints, or with delinquencies and evictions. You will also have the freedom to live wherever you want – or at least take a vacation – without having to worry about the maintenance and management of your real estate investment.

Common examples of real property owned by tenancy-in-common are multi-family residential properties, hotels, large single tenant retail properties, multi-tenant business parks and malls, and leased office buildings. In fact, any relatively stable income-producing property that qualifies as a “like-kind” exchange under Section 1031 can be owned as a tenancy-in-common.

Leases or rental interests do not qualify for a Section 1031 exchange because they are not considered to constitute property ownership.

There is, however, one important exception to this rule. The IRS has ruled that a lease for 30 years or longer is a qualifying property interest under Section 1031.

Land leases for 30 years or longer are most common in geographic areas like New York, Boston, Chicago, and other high density cities where available land for new development is scarce and where a specific parcel might not be able for sale, but is available for lease.

Such long term land leases are also used by the government to lease land that cannot be sold. Under most 30-year or longer leases, the tenant constructs an improvement for the tenant’s own long-term use. The receipt of prepaid lease payments, whether for a 30-year lease or not, are taxed as ordinary income and will not qualify for tax-free exchange treatment.

Co-ownership interests in real property, such as joint tenancy and tenancy-in-common, must be sharply distinguished from partnership interests in real property.

The Internal Revenue Code specifically excludes partnership interests from the tax-free exchange provisions of Section 1031. If either the relinquished property or the replacement property is determined by the IRS to be a partnership interest, the transaction will not qualify as an exchange under Section 1031.

The IRS’s rationale for this exclusion is that a partnership interest, unlike a joint tenancy or a tenancy-in-common, is not direct ownership of real property, and therefore is not qualified “like-kind” property under Section 1031. As the IRS sees it, an interest in a partnership that owns real property is an interest in the partnership, not in the property. A partnership interest is a personal property interest (like stocks, bonds, and other securities) and not “like-kind”with real property.

The exclusion of partnership interests from the exchange provisions of Section 1031 applies to all forms of partnership, including both limited and general partnerships, and applies regardless of what kind of assets are owned by the partnership.

For example, an interest in a partnership that owns an office building or a farm is excluded from the tax-free exchange provisions of Section 1031, despite the fact that the underlying assets owned by the partnership are real property. For this same reason, shares in a real estate investment trust (REIT) are excluded from the tax-free exchange provisions of Section 1031 despite the fact that the underlying assets owned by the trust are real property.

Since partnership interests are excluded from the tax-free exchange provisions of Section 1031, you might ask whether real property held by partnerships can be exchanged under Section 1031. The answer is “Yes.”

Partnerships, just like individuals or corporations, can exchange property as the taxpayer under Section 1031 and avoid capital gains taxes and recapture of depreciation. For example, if a partnership owns an office building, the partnership can exchange that office building under Section 1031 for another office building, or an apartment complex, or any other qualified “like-kind” property.

The partnership, like any other taxpayer, will not have to pay capital gains taxes or depreciation recapture as a result of this exchange of like-kind property. It cannot, however, exchange a share of the partnership itself.

There are occasions when it makes financial sense to split up or liquidate a partnership and exchange the real property assets held by the partnership to take advantage of the tax avoidance benefits of Section 1031. For example, the partners may have developed divergent goals or simply no longer get along well together. Or the partners may want to sell the partnership property, but each partner wants to do with his share of the proceeds as he pleases.

In such cases, there are two basic strategies: drop and swap and swap and drop.

In a drop and swap transaction, a partnership first distributes assets to the partner(s) who want to cash out of the partnership (the drop), and then these partners exchange the assets, as individual owners, under Section 1031 (the swap).

The partnership can be liquidated and the partnership’s entire real property assets distributed individually to each partner. Or, rather than liquidate the entire partnership, one or more of the partners can opt out of the partnership and receive some of the partnership’s real property assets, either as sole owners or as holders of an undivided interest in co-tenancy with the partnership.

In a swap and drop transaction, the partnership first exchanges the property under Section 1031 (the swap), and then distributes the replacement property to he individual partners (the drop).

Although the sharp distinction between interests in partnerships (which are excluded from tax-free exchange under Section 1031) and fractional co-ownership of real property as joint tenants or tenants-in-common (which are qualified “like-kind” property) must be kept in mind, the line between a partnership interest and fractional co-ownership interest is sometimes more fine than bright.

Unfortunately, neither the statute, the Internal Revenue Code, the IRS, nor the courts have provided certainty in this area. For this reason, it is critically important that you consult with your attorney and your tax advisor before entering into a Section 1031 exchange involving property that could conceivably be considered a partnership interest.

For more information on this topic, and for everything you need to know about 1031 exchanges, see our book 1031 Exchanges Made Simple, available at Amazon.com.

To contact Melissa J. Fox about serving as a qualified intermediary or for other 1031 exchange services, send an email to strategicfox@gmail.com

For Part Two of this article, click here.

For Part Three of this article, click here.